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Leah Co is an all equity financed company which wishes to appraise a project in a new area of activity. Its existing equity beta is 1.2. The industry average equity beta for the new business area is 2.0, with an average debt / debt + equity ratio of 25%. The risk-free rate of return is 5% and the market risk premium is 4%.
Ignoring tax and using the capital asset pricing model, calculate a suitable risk-adjusted
cost of equity for the new project.Solution- In this case, candidates should ignore the existing equity beta of 1.2 and use the industry average equity beta of 2.0. This proxy beta needs to be ungeared.
?a = 2 x (75/100) = 1.5
The asset beta does not need to be regarded.
Using CAPM, ke = 5 + 1.5 x 4 = 8.96% = 11%
My question to you is why the asset do not need to be regeard??Leah is an all equity financed company, and therefore the equity beta is the same as the asset beta which is this example is 1.5.
Have you watched my free lectures on CAPM and on the effect of gearing? The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.
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